Citi, B. of A. drop on nationalization concerns

'Privately held' banking system is correct way to go, White House says

By

AlistairBarr

SAN FRANCISCO (MarketWatch) -- Bank of America Corp. shares hit a record low and Citigroup Corp.'s stock slumped to an 18-year low Friday on concern the two financial giants may be nationalized.

Citigroup dropped 22% to $1.95, their lowest level since early 1991. Bank of America fell 3.6% to $3.79 and earlier changed hands at a lowest-ever $2.53, according to FactSet Research data.

'The hybrid character of banking -- always a joint venture between private capital and governmental liquidity safety nets -- is morphing more and more toward government-sponsored banking.'
Paul McCulley, Pimco

Senate Banking Committee Chairman Christopher Dodd said banks may have to be nationalized for a short time, according to Bloomberg News.

White House press secretary Robert Gibbs tried to calm such concern, saying President Barack Obama's administration thinks a "privately held" banking system is the correct way to go. See full story.

The comments seemed to help as shares of Citigroup and Bank of America recovered some losses during afternoon action. Bank of America shares turned positive briefly before falling back at the close.

A Citigroup
C, +1.85%
spokesman highlighted the bank's high Tier 1 capital ratio, a measure of financial strength, and said it continues to cut assets on its balance sheet, reduce expenses and streamline its businesses for future "profitable growth." He declined to comment further.

Citi isn't having conversations with the U.S. government about nationalization, Reuters reported, citing two unidentified people close to the New York-based bank. However, those people also said the U.S. Treasury has not disclosed much more to Citigroup than it has to the broader public about its plans for the banking sector.

"We see no reason to nationalize a bank that is profitable, well capitalized and actively lending," said Scott Silvestri, a spokesman at Bank of America
BAC, +1.68%

Chief Executive Ken Lewis reportedly said during a senior leadership meeting Thursday that policy officials in Washington have assured him nationalization isn't an option under consideration. He also urged the government to say this publicly, The Wall Street Journal reported Friday.

"There are a lot of rumors in the market, as always, but you should not regard these as any indication of the policy of this Administration," Treasury spokesman Isaac Baker said. "As Secretary Geithner has said, we will preserve a financial system that is owned and managed by the private sector."

List grows

The U.S. government injected more than $100 billion into the nation's largest banks last year to bolster capital that's been whittled away by a surge in defaults on mortgages and other loans.

Citigroup and Charlotte, N.C.-based Bank of America have received the most support, getting government guarantees to protect them against losses on toxic assets as well as receiving direct investments.

However, shares of the two banks continued to slump, prompting some experts to call for the government to take control, at least temporarily.

"The list of those people in favor of nationalization, our long-standing recommendation for the biggest banks in the financial sector, continues to grow," said Barry Ritholtz, director of equity research at quantitative-research firm Fusion IQ.

Ritholtz cited Alan Greenspan, the former chairman of the Federal Reserve Board, as well as the bearish New York University economics professor Nouriel Roubini among several proponents of bank nationalization.

'Proper clean-up'

There are two key elements missing from the effort to avoid a near economic depression, Roubini said Thursday.

The first is "a proper clean-up of the banking system that may require a proper triage between solvent and insolvent banks and the nationalization of many banks, even some of the largest ones," he explained.

The other is "a more aggressive and across-the-board reduction in unsustainable debt burden of millions of insolvent households," he added. This would include a reduction in the principal owed on mortgages, not just mortgage-payment relief, Roubini noted.

"Talk of nationalizing Citi and others is placing pressure on share values," said Egan-Jones Ratings, a rating agency that's paid by investors rather than issuers. "However, the structure is key; if nationalization occurs and the U.S. guarantees all obligations, credit quality will improve. Most other scenarios do not help."

Counterparty risk jumps

Meanwhile, counterparty-credit risk in the derivatives market climbed to the highest level since Oct. 10 on such concerns, according to Credit Derivatives Research.

The index is up more than 57 basis points since last week. A basis point is one one-hundredth of a percentage point.

Credit-default swaps are a common type of derivative contract that pay out in the event of default. When prices on swaps rise, it means investors are more worried about defaults.

Such prices on Citigroup jumped fully 75 basis points on Friday and are wider by roughly 50% in the past week, according to CDR. For their part, prices on Bank of America's credit-default swaps climbed 38 basis points and are 60% wider than a week ago.

Nationalization, effectively speaking

Some big banks have already lost quite a lot of control over their destinies.

The federal government's already a major investor and many politicians are pushing the industry to lend more, despite a recession that's cutting loan demand and reducing the number of creditworthy borrowers.

Banks that accepted government support last year at the urging of the Treasury also have to stick to strict new executive-compensation guidelines, while Bank of America was reportedly pushed by authorities into closing on the acquisition of Merrill Lynch & Co. See full story.

With the government already holding some sway over lending decisions, compensation and acquisitions, these big banks may already be effectively nationalized.

The latest government initiative to stabilize the financial system has only increased such concern.

The Financial Stability Plan, unveiled last week by Treasury Secretary Timothy Geithner, includes a so-called "stress test" that all U.S. banks with at least $100 billion in assets will be required to take.

If lenders are found to need more capital after the test, the government said it will invest more money via preferred securities that could converted into common shares if needed, raising fears of shareholder dilution.

Indeed, many big banks have such low stock-market valuations that if the government converts its new stakes into common stock, it may end up owning at least half of the equity in these institutions.

The Treasury is expected to allocate at least $100 billion from the remaining $350 billion from the Troubled Asset Relief Program to a bank-bailout fund that would buy these convertible preferred shares.

Trial separation, not divorce

Banks have always operated with some level of government support, such as deposit guarantees from the Federal Deposit Insurance Corp., according to Paul McCulley, a managing director and portfolio manager at bond giant Pimco.

"The hybrid character of banking -- always a joint venture between private capital and governmental liquidity safety nets -- is morphing more and more toward government-sponsored banking," he wrote in a note to clients Friday.

"I know that is harsh, but sometimes the truth is harsh. Capitalism and banking may not be divorced, but certainly are engaged in some form of trial separation," he said.

"It's not wholesale nationalization. And it's not likely to become that," McCulley added -- but that's only because the Treasury, the FDIC and the Federal Reserve "are committed to doing whatever it takes to prevent that outcome."

By the same token, they also want to get the U.S. out of the recession by spurring more lending, he noted.

"Will it work? Judging from the markets' collective reaction to Treasury Secretary Geithner's announcement last week of the new administration triage plans, there is room for doubt," McCulley said. "I do not, however, take one-week swings in the markets as indicative as to where this game will end."

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